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AT&T does an about face on WarnerMedia

| May 21, 2021

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.

In an interesting turn of events, AT&T (T) recently announced that it would be spinning out WarnerMedia, which would then merge with Discovery Communications (DISCA), despite having closed on the Time Warner Inc. transaction less than three years ago. Management intends to refocus their efforts and financial resources on the core telecommunications business, a departure from its strategy behind the Time Warner acquisition of marrying distribution with content. The deal proceeds will help T attack its large debt load, which increased with its $27 billion spend in the recent C-Band spectrum auction. Net debt should be reduced by $43 billion upon closing of the transaction, expected in mid-2022, bringing the company much closer to its 2.5x net leverage target. The deal will fast forward its debt reduction target by a full year, helping T spreads collapse much closer to those of peer Verizon Communications (VZ).

We highlight the curve relationship between the two credits in Exhibit 1.

Exhibit 1. T vs. VZ Spread Curves

Source: Bloomberg TRACE; Amherst Pierpont Securities

Unlocking Value for T Shareholders While Improving the Balance Sheet

The deal, which is structured as a Reverse Morris Trust, will spin out WarnerMedia, which will be combined with 100% of DISCA.  T shareholders will receive 71% of the common equity of the new company while DISCA will own the remaining 29%.  T is expected to receive a combination of cash and debt relief totaling $43 billion from WarnerMedia at the spin which will bring net debt/EBITDA to 2.6x at close.  According to T’s 8-k filed at time of the announcement, the WarnerMedia Spinco with assume the debt of the existing WarnerMedia business as well as pay a cash dividend T.  Additionally, in certain circumstances, the WarnerMedia Spinco will issue to T debt instruments as well.  T will continue with its debt reduction efforts post spin and plans to achieve net leverage of 2.5x by year-end 2023, which is one full year ahead of original expectations.

Exhibit 2. Transaction Summary

Source: AT&T Company Presentation; Amherst Pierpont Securities

The New T

The spin allows for T to now focus on its Mobility and Fiber Broadband businesses.  On the Mobility side, T will look to continue to make profitable market share gains while investing transformation savings back into growing its customer base and retention of existing customers.  With the recent C-band spectrum, T will also focus on accelerating the roll out of next generation network services.  On the Broadband side, T plans to double its total addressable market for fiber while increasing customer penetration.  Additionally, they plan to aggressively market to businesses, in an effort to improve the adoption rate.

While the Time Warner acquisition was going to help address the maturity of the phone business, the recent C-band spectrum spend highlights the importance of remaining competitive.  T released annualized pro forma growth expectations post spin with revenues expected to grow in the low single digit range (2022-2024 CAGR).  Adjusted EBITDA is now being forecasted to grow in the mid-single digit range, fueled by strong ROI from both its Mobility and Fiber Broadband investments.  Adjusted EPS is also expected to be up in the mid-single digit range based on the aforementioned EBITDA growth coupled with reduced interest costs associated with the smaller debt profile.  T plans to continue to pay a dividend but will be cutting its payout ratio to the 40%-43% range (down from nearly 55% in 2020). The savings from the dividend reduction will be reinvested back into the 5G and Fiber businesses.  Free cash flow is now expected to be above $20 billion on an annual basis.   We note that while T generated free cash flow of just over $29 billion for fiscal 2020, the expectation for free cash flow to be above $20 billion post spin is roughly $4 billion higher than annual free cash flow generated pre-Time Warner.  We do not expect T to consider share repurchases until it reaches its 2.5x net leverage target.

Agencies Affirm Ratings Upon Deal Announcement

Moody’s affirmed T’s Baa2 rating and stable outlook post the announcement and highlighted that they believe the company’s second priority, after business reinvestment, will be to return the balance sheet to historical strength levels.  Moody’s noted that they believe that is the correct priority order for T going forward. The agency also viewed the cut to the “outsized” dividend positively, as the proceeds from the reduction can help to further execute on its priorities.  The stable outlook reflects the recovery and improvement in T’s operating performance as the pandemic subsides.

S&P took a slightly different approach by affirming the BBB rating while moving the outlook to stable from negative.  S&P noted that they view the transaction favorably for T’s overall business risk.  While the wireless business will now represent 70% of total EBITDA, they view the cash flows from the Mobility business to be relatively predictable given that they are subscription based.  Furthermore, the debt relief should bring leverage comfortably below the agency’s threshold trigger for a downgrade.

Additionally, Fitch also affirmed their BBB+ ratings and stable outlook particularly due to the fact that the spin enables the company to hit its leverage target by 2023.  Fitch forecasts that T’s EBITDA margins should improve to the high-30% range by 2024 which further helps to improve leverage metrics.  Fitch believes the focus on the company’s core business helps it better to compete with T-Mobile, which combined with Sprint in April 2020.

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